Question

Given the danger of bank runs, why do banks not keep the majority of deposits on hand to meet the demands of depositors?

Short answer

Banks do not keep the majority of deposits on hand to meet the demands of depositors due to their need to generate profits through lending, existing reserve requirements, central banks' financial support, and deposit insurance systems. The fractional reserve banking system ensures financial stability while allowing banks to operate profitably.

Step-by-step solution

1. Understand Bank Business Model and Bank Runs

: Banks operate by accepting deposits from customers and using those deposits to make loans to other customers. By doing this, banks generate profit from the interest earned on loans. However, during times of financial instability or crisis, depositors might panic and try to withdraw all their deposits at once. This scenario is known as a bank run, and it can lead to the collapse of the bank that faces the situation.

2. The Concept of Fractional Reserve Banking

: Fractional reserve banking is the system used by banks around the world, where they are only required to keep a certain percentage of their deposits as reserves. This percentage is known as the reserve requirement. It means that banks can use the majority of their deposits to make loans, which generates profit for the banks.

3. Reasons for Not Keeping Majority of Deposits on Hand

: There are a few reasons why banks do not keep the majority of deposits on hand to meet the demands of depositors: a. Profitability: Banks make a profit by lending out deposited money to borrowers, and any money kept as reserves does not generate a profit. Thus, banks have a financial incentive to use as much of their deposits as possible for loans. b. Reserve Requirements: With the reserve requirement in place, banks can be confident that they will usually have enough of funds on hand to meet the withdrawal demands of their depositors. The reserve requirement is set to ensure the stability of the financial system and protect banks from unexpected cash outflows. c. Central Banks' Support: In case of unexpected liquidity issues, central banks can provide emergency funds to commercial banks through various mechanisms such as lender of last resort function, discount window lending, or open market operations. These measures ensure that banks can access funds to meet depositor demands in times of stress, reducing the need to hold additional reserves. d. Deposit Insurance: Most countries have a deposit insurance system, where the government guarantees a certain amount of depositors' money in case a bank fails. This helps to build confidence in the banking system and reduce the likelihood of bank runs.

4. Conclusion

: In conclusion, banks do not keep the majority of deposits on hand to meet the demands of depositors because of their need to generate profits, the existence of reserve requirements, the support provided by central banks, and deposit insurance systems. These factors help to ensure the stability of the financial system while allowing banks to operate profitably.